Blog: Regulations coming to ESG investing (environmental, social, and governance) – and that’s a good thing – WRAL TechWire

Editor’s Note: This is the latest in a series on stakeholder capitalism and environmental, social, and governance (ESG) authored by University of North Carolina at Chapel Hill professors affiliated with the Kenan Institute of Private Enterprise.  According to the Kenan Institute, Stakeholder capitalism is the idea that businesses would improve societal outcomes by focusing on a mandate broader than that which benefits shareholders alone. While this seems like a great idea in principle, it is challenging to implement in practice, especially when the interests of different stakeholders come into conflict, thus negating win-win solutions. The collection of work below provides rigorous solutions-based analyses of stakeholder capitalism which promote win-win solutions when they are available, or can become available with the right set of policies, while also acknowledging and creating frameworks when difficult tradeoffs must be made.

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CHAPEL HILL – In early 2023, the Securities and Exchange Commission is expected to finalize its first ruling on mandatory climate risk disclosures for public companies. The proposed rules, introduced last March as a way to improve transparency for investors, expand the requirements for corporate disclosure of financial risk to include climate-related risks and their potential impact on companies’ business models and financial outlooks. Significantly, under the new rules, large companies would be required to disclose – and have independently verified – greenhouse gas emissions they generate or purchase, known as scope 1 and scope 2 emissions, respectively.

The most controversial aspect, however, concerns indirect emissions generated by a company’s full supply chain – namely, scope 3 emissions, a broad category extending from the extraction of raw materials that it buys from suppliers to the end use of goods that it sells. These disclosures would be limited only to situations where they were deemed “material,” and scope 3 disclosures would not need third-party verification and would be protected from legal liabilities.

The proposal also increases the accountability of companies that have issued emission targets and climate plans by requiring them to outline how they intend to reach those targets along with a time frame. Finally, under the new rules, companies would have to disclose any internal carbon prices, if such measures are adopted, and how they are set.

The SEC’s proposed new ruling is ambitious. It significantly expands the scope of greenhouse gas reporting in the U.S., which, at the moment, is required only from the heaviest emitters. Indeed, while 90% of S&P 500 companies voluntarily disclose statistics on carbon emissions or how much renewable energy they use, those statistics are generally not reviewed by regulators, and only a fraction of companies report similar metrics or mention climate change in their filings. Under the new law, firms would have to take climate-related risks more seriously in their governance and operational strategies.

Perhaps more important are the mandatory climate risk reporting standards. A standardized and trustworthy reporting regime has the potential to be the game changer, providing much-needed data that’s useful to many stakeholders, from regulators to investors. Whether it is used as a basis for carbon taxes or to create a “shadow carbon price” where stock prices of high emitters are effectively penalized by investors, the reporting requirement would provide the data on carbon emissions that is critical for tackling climate change in any meaningful way.

Why is ESG (Environmental, Social, and Governance) investing becoming such a controversial topic?

Big Picture

In essence, the SEC’s new disclosure rules aim to better measure climate risks – perhaps defining a coming-of-age moment for sustainability disclosures. By some estimates, ESG-informed investment could reach $50 trillion in assets by 2025. Yet, it is still difficult to assess whether such a significant reallocation of capital toward sustainable activities moves the needle for climate transition. The problem is that ESG data in general come from a hodgepodge of fragmented, incomplete and voluntary disclosures that lack standardization.

The moment appears to have arrived, however, when regulators feel more of a sense of urgency. Perhaps it is a realization that climate change is a more salient economic risk and that existing disclosures are simply not adequate for understanding these risks. Another driver is the demand from shareholders for more information – especially very loud ones, institutional investors and asset managers, representing tens of trillions of dollars.

The SEC is not alone. Tighter regulatory oversight of ESG investment mandates is making progress on both sides of the Atlantic. In addition to the SEC, the International Sustainability Standards Board (ISSB), created by the International Financial Reporting Standards Foundation that administers the IFRS accounting standards, is working on a unified set of global third-party nonfinancial disclosure standards similar to financial ones used in company filings. The European Union, which has consistently acted ahead of other regions, has already signed into law its own disclosure mandate: the Corporate Sustainability Reporting Directive (CSRD), which requires an extensive set of disclosure standards in multiple environmental, social and governance domains. In fact, CSRD goes further than the SEC’s proposed rules in coverage, extending to all private and public companies with at least 500 workers – nearly 50,000 medium-size and large companies. Importantly, the EU’s rules apply the “double materiality” principle, requiring companies to measure their impact on people and the environment directly. The proposed SEC rules, on the other hand, emphasize investor-focused risk governance and financial materiality, given the SEC’s narrower mandate of investor protection.

Still, the SEC’s new ruling faces a tough road. It has already come under attack from some pro-business groups, arguing it will drive up costs. Also of concern is whether the proposal exceeds the SEC’s authority. If the Supreme Court’s recent decision to curb the power of the Environmental Protection Agency is an indication of what the future might hold, it is likely that the final rules will face legal challenges ultimately decided at the highest level.

Nearly $2 trillion in environmental, social & governance (ESG) assets have vanished

The Case for Optimism

There are several reasons to be cautious about the impact of new sustainability disclosure rules. Accounting standards do not stop companies from being creative with their earnings reports. As the old adage goes, what gets measured, gets manipulated: Companies may report greenhouse gas emissions in their annual reports, but ensuring data quality will remain challenging. Investors’ ability to make accurate and comprehensive assessments of companies’ climate-related risks depends crucially on the trustworthiness of their disclosures. At the moment, widespread and trusted disclosures are not readily available. MSCI reports that among the nearly 10,000 listed companies that make up its world index, disclosure rates for scope 1 and scope 2 emissions are below 40%. That share is much smaller for private companies.

The measurement of scope 3 emissions will be even trickier. Is the oil company responsible for the emissions from a gas tank, or the car company? What kind of jockeying will that create? And what if banks had to disclose their scope 3 emissions? The reporting of scope 3 emissions remains central to the debate around the SEC’s new proposal. While new rules require the information only if material – that is, what a reasonable investor would expect to find useful – environmental groups are concerned that leaves it up to companies to determine the materiality of their emissions.

Still, mandatory regulation of such disclosures should tighten up the process. The caveat, however, is that for the rules to have a global impact, the U.S. needs to be on board. Only a consistent, globally coordinated disclosure standards from the ISSB, the SEC and the EU can limit the burden on reporting companies and keep costs of reporting manageable.

Ultimately, the challenge is whether the new rules can make companies respond in a socially optimal way to the costs associated with their generation of greenhouse emissions – what economists call “internalizing their externalities.” For investors and markets to facilitate this requires reliable and easy-to-access information. Optimal disclosure requirements and regulatory scrutiny provide the information necessary to direct capital where it best meets the objectives of investors – whether the goals be pecuniary or nonpecuniary. With greater supervisory oversight and more standardized climate risk disclosures, investors can better assess risks and opportunities. Furthermore, there is an expectation that such mandatory disclosure frameworks aimed at public investments will begin to filter through to private investments as well. The hope of investors supporting market-based solutions is that, ultimately, capital markets will help companies internalize their externalities by rewarding those that reduce carbon footprints through higher asset prices and lower costs of capital, effectively punishing those that do not.

Academic research shows the value of standardized, audited financial information for the development of capital markets, economic growth and corporate governance. Sustainability disclosures should be no different.

© Kenan Institute of Private Enterprise

Kenan Insights: Does ESG investing generate higher returns?

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